How target cost contracts can reduce risk of cost and time over-runs

Construction cost management is an important topic in global construction markets as firms seek to reduce unnecessary costs. 

Under the target cost model, the owner pays a fixed security covering profit, preliminaries and other overheads and reimburses the costs incurred by the contractor during the project.

The actual cost to perform the work is then assessed against a target cost for the work which was agreed at the beginning of the project. Any savings or cost overruns made in the final project cost are shared between the owner and contractor based on an agreed formula, incentivising contractors to make savings and bring projects within pre-determined budgets.

In Hong Kong SAR, the government prefers to adopt the ‘target cost’ option of the new engineering contract (NEC) for more complex and higher risk projects, or where the scope of works cannot be clearly defined.

Although these contracts can be challenging and more costly to administer, they achieve the benefit of controlling costs and enhancing efficiency when used appropriately. It is important for the construction industry to fully familiar with the nuances of target cost contracts both to realise the benefits of this form of contract and to effectively manage associated risks.  

What is a target costs contract and how does it operate? 

Target cost contracts are different from traditional contracts primarily in pricing structure and risk allocation. Traditional contracts typically involve fixed prices, with the risk loaded more onto contractors.

Working towards a mutually agreed target with a subsequent reimbursement means the risk is shared more evenly between the parties. The contractor is paid for work done on a cost reimbursable basis and the amount they are paid at each assessment interval, commonly monthly, reflects their actual cash flow.

Disputes overcompensation events would not affect the amount the contractor is paid, who is paid what they spend based on the contractor’s accounts and records until the point when the gain share / pain share is assessed. This seeks to reduce the pressure on the contractor’s cash flow, and they do not to have allow for funding the works in their tender price.

Under terminology unique to NEC contracts, the contractor is to be paid the “Price for Work Done to Date” (or PWDD) during the works, plus the “contractor’s share” arising from what is described as the pain / gain share mechanism.

PWDD is calculated based on a formula, which is “defined costs” plus a “fee”.

‘Defined cost’ is the “cost of the components in the schedule of cost components, less disallowed cost”. It generally means all expenses incurred by the contractor for carrying out the works under the contract, excluding disallowed cost and items covered by the fee.

“Disallowed cost” are costs incurred by the contractor, but not recoverable under the contract. They are borne entirely by the contractor and are typically those incurred due to some default or negligence on the part of the contractor’s employees, subcontractors or suppliers. For example, costs not justified by the accounts and records, not properly incurred, not used to provide the works, or costs used to correct defects for example.

“Fee” is an allowance which is expressed as a percentage that the contractor puts in during the tendering stage to cover overheads, profits and costs which are not covered by the “defined cost”. The “fee” is calculated by multiplying the fee percentage by the amount of “defined cost”. Any costs that are not “defined cost” will be considered as included in the “fee”. This means that the “Fee” will necessarily include profit and major parts of head office overheads and other costs which cannot otherwise be recovered as “Defined Cost”.

Under the NEC target cost contracts, there is in principle no limit on the amount of PWDD. Instead, following the completion of the works, the PWDD, the total cost, falls to be measured against the target cost, referred to as the “total of the prices”. This ‘pain / gain mechanism’ is at the heart of target cost contracts and forms the key driver in aligning the parties’ objectives to work together to create efficiency and reduce costs.

Broadly speaking, if the PWDD is lower than the target cost, the contractor is entitled to be paid a “gain share"; if the PWDD is higher than the target cost, the contractor pays its share of the excess and feels the ‘pain’. This is referred to as the “Contractor’s Share”. The simplest pain share / gain share allocation is a straight 50:50 split of all over and underspend. In practice, this is often altered to allow a sliding scale of percentages to be used whereby the client allocates increasing or decreasing percentages of pain share / gain share between the parties. The owner may at a certain level allocate 100% percent of overspend and 0% of underspend to the contractor.

An example of the pain / gain mechanism in operation, assuming a project has adopted a simple 50-50 split for gain share and pain share, subject to a final pain cap of 120%, would be:

• If the share range is less than or equal to 120%, then the contractor’s share percentage is 50%. 
• If it is greater than 120%, the contractor’s share percentage is 100%.

Using the example above, the “contractor’s share” and final payment to the contractor for working on a project with a target cost of HK$100 million (approx. US$12.760 million) would be:

• If contractor A’s final PWDD was HK$90 million and the target cost was HK$100 million, then the contractor’s share would be HK$5 million gain share, with a final amount due of HK$95 million. 
• If contractor B’s final PWDD was HK$120 million and the target cost was HK$100 million, then the contractor’s share would be HK$10 million pain share, with a final amount due of HK$110 million. 
• If contractor C’s final PWDD was HK$90 million and the target cost was HK$100 million, then the contractor’s share would be HK$40 million pain share, with a final amount due of HK$110 million.

Therefore, although the costs spent by contractor C in completing the works is the highest at HK$150 million, it eventually receives the same payment as contractor B, after factoring in a negative contractor’s share of HK$40 million. In other words, contractor C absorbs all ‘overspend’ beyond 120% of the target cost. If the target cost remains unchanged at HK$100m, the maximum amount due to a contractor would be capped at HK$110 million, regardless of the costs required by the contractor to complete the contract. To address this risk, there are specific circumstances where the contract provides for a contractor’s entitlement to adjust the target cost, such as via compensation events and price fluctuations.

To best mitigate the risk of triggering the pain share cap under a target cost contract, two common objectives for contractors would be to carefully manage its PWDD and ensure the target cost is adjusted as provided for in the contract. 

The adoption of target cost contracts in Hong Kong 

Since 2009, the government has gradually extended NEC form to a wide range of works categories. It is the government’s own forecast that most forthcoming M5 tenders, which have an estimated cost exceeding HK$400 million, between 2024 Q4 and 2025 Q3 will adopt the target cost option of NEC contracts.

Lessons have been learned and experience gained in the past 15 years of delivering complex projects in Hong Kong using the NEC target cost model. There are many successful stories on how the risk of cost overrun and delay is minimised through the collaboration, spirit of mutual trust and common goals shared among the main contractor, sub-contractors, project team and other stakeholders under this procurement model. The risk of overspend and the benefit of savings are shared. The government is given visibility of the contractors’ costs to know if and how they are making or losing money. This approach has led to a substantial reduction in the potential for claims and disputes between the government and contractors.

Specific concerns, however, have also been raised by users in relation to the challenges encountered in working on the NEC target costs contracts:

Cap on pain share 

For most target cost contracts awarded by the government, the ‘default’ arrangement is to firstly adopt a simple 50:50 split for all gain share and, secondly, split the first 10% of overspending equally between the parties for pain share, but allocate all spending greater than 110% wholly to the contractor to limit the financial risk to the government. This reduces the financial exposure to the government but conversely increases the financial risk for contractors.

Interim application of pain share

It was the original intention of the NEC target cost contracts for the allocation of pain and gain to occur after completion of the works and not on an interim basis. This arrangement is amended in NEC ECC Hong Kong edition, by introducing an earlier and interim assessment of the contractor’s share. If the project manager’s forecast of the final PWDD exceeds the forecast of the target cost, the resulting pain share will be immediately deducted from the next monthly payment due to the contractor.  

Adjustment of target cost 

A target cost is subject to positive and negative change, with grounds for changing are stated in the contract. It is essential that changes are agreed as soon as they occur, if not in advance. This enables the target cost to remain reflective of the current scope of works and the ‘pain share / gain share’ calculation to remain valid. In the event changes are not proactively managed in accordance with the prescribed timeframes, project managers often defer pricing compensation events and look for a simple way out in changing the target cost value to match the actual expenses after the impact of a compensation event is over and all relevant costs have been incurred.  

Disallowed costs  

There are no general grounds under the NEC for disallowing costs incurred due to the contractor’s inefficiency and only limited reasons are provided for disallowing costs within the contract.

This reflects the fundamental nature of a target cost contract where the risk of good performance by the contractor is shared via gain share, and poor performance shared via pain share. In practice, disallowed costs have sometimes been used to reduce project costs and avoid the other party having an overspend. This has led to closer scrutiny by some project managers who may, for example, seek to disallow costs not just when records are not available, but also when they are inconsistent or incomplete.

The combination of all these challenges could result in a growing lag over time between when costs are incurred by a contractor and when such expenses are reimbursed, meaning contractors may have to fund works for a prolonged period during the later stage of a project when the pain share cap is reached but the target cost is not yet updated to reflect changes in cost due to, for example, compensation events. Although some of these issues are down to culture and experience, most of these pitfalls can be overcome by true collaboration among all stakeholders, faithfully implementing all contract terms under the spirit of NEC.

Hong Kong SAR’s construction industry is crucial in supporting the city’s development and connection with the Greater Bay Area. The industry is facing a number of challenges such as high construction costs and cash flow management. If used wisely, NEC and target cost contracts can provide the perfect solution to resolve some of these challenges, and it is expected that the use of the target cost contracts will only become more prevalent in both public and private procurement in Hong Kong. 

A version of this article was previously published in The HK Lawyer.

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• Allocating the risk of physical conditions in NEC4
• Understanding Hong Kong SAR NEC compensation events ‘crucial’ to projects’ success
• Optional clauses in Hong Kong SAR NEC forms can boost construction project outcomes
• Hong Kong SAR NEC forms hold limits to instructing changes to construction works’ scope
• Hong Kong SAR NEC forms encourage proactive communication
• Impact of potential variations of scope in Hong Kong SAR NEC forms must be thoroughly assessed
• Clarity on compensation events in Hong Kong SAR NEC forms can help to avoid construction disputes
• Using the NEC4 standard form contract for construction projects in Hong Kong SAR